WINNER: SPEAR’S FINANCIAL BOOK OF THE YEAR 2009
Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe
Little, Brown, 338pp
Review by Christopher Silvester
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A ccording to Gillian Tett in this fizzing account of the derivatives market over the past decade and a half, the root of our current problems can be dated back to a summer weekend in 1994 when the derivatives team of J.P. Morgan enjoyed a corporate retreat in Boca Raton, Florida.
For it was during that weekend, as their leader Peter Hancock recalled for her, that they hatched the idea of ‘using derivatives to manage the risk attached to the loan book of banks’. So that is when Tett’s story begins.
Starting out in the 19th century with commodities futures and options, derivatives only expanded into the world of finance in the 1970s, with interest-rate swaps and options. In those days, the J.P. Morgan swaps team, led by Connie Volstadt, was a band apart. It prized its autonomy and scorned senior management; while senior management regarded the swaps traders ‘as a bunch of brilliant but stroppy teenagers’.
For those who put their faith in future regulation to avoid a repetition of the recent catastrophe, it would be salutary to know that it was the effort to get around the 1933 Glass-Steagall Act which drove the market for derivatives. Since Glass-Steagall didn’t apply overseas, it was J.P. Morgan’s London subsidiary, Morgan Guaranty Limited, which became ‘the epicentre of experimentation’ as far as derivatives were concerned.
Derivatives were a double-edged sword. For some investors they offered a means of controlling risk; for others they represented high-risk bets which could bring in windfall profits. Tett, who is the capital markets editor of the Financial Times, was one of the first journalists to identify the potential systemic risks of structured credit instruments.
With J.P. Morgan constrained by the Basle banking accords and the derivatives department constrained by its own credit limit, derivatives offered a way to move risks off balance sheet. Blythe Masters, a young British Oxford economics graduate, created the first credit default swap (CDS), an innovation intended to disperse risk, between ExxonOil and the European Bank of Reconstruction and Development, in 1994. Once CDS had been proven to be successful, the natural urge was to ‘industrialise’ the trade in such instruments for the mass market.
This innovation was followed by another, the ‘broad index secured trust offering’ (Bistro), a bundle of credit notes sold from inside a tax-efficient, offshore special purpose vehicle (SPV) and backed by triple-A-rated US Treasury bonds. As a result, in 1998 ‘the market for credit derivatives had gown overnight from a cottage industry into a bazaar where tens of billions of risk was changing hands’. The J.P. Morgan team had stumbled upon ‘a financial Holy Grail’. As one journalist recalled, they ‘thought they were the smartest guys on the planet’.
K eeping reserve capital on the bank’s books to cover the least risky element in a Bistro, or collateralised debt obligation (CDO), as it came to be known, seemed pointless. After all, reasoned Peter Hancock, why assume ‘that the financial equivalent of an asteroid strike would devastate Wall Street’? Nonetheless Blythe Masters came up with a way of insuring the risk of ‘super-senior’ (triple-A-rated) debt through the US insurance giant AIG.
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Another woman at J.P. Morgan, Terri Duhon, took on the task of applying the same principles to the mortgage market. Whereas with bundles of corporate loans, the companies were named and their track records available for examination, mortgage holders were anonymous and their credit histories undisclosed. If defaults on mortgages were highly correlated, it might be dangerous. J.P. Morgan looked at mortgage derivatives, concluded that they were staring into an abyss, and declined to plunge headlong into it. Other banks were not so squeamish.
For while the J.P. Morgan team were right to have faith in Bistro CDS, these credit derivatives eventually produced ‘some very perverted offspring’. Not only that, of course, but it turned out that insuring super-senior debt through AIG was a chimerical form of securitisation, since AIG was practically bust.
When Jamie Dimon became CEO of J.P. Morgan in 2004 he announced a push for securitisation. But fortunately his bank’s derivatives team again decided against plunging into this market because they concluded one could not make significant profits out of selling mortgage-based CDOs. Blythe Masters was unable to understand how other banks were finding mortgage credit to be such a profits bonanza. She was ‘so steeped in the ways of J.P. Morgan,’ says Tett, ‘that it never occurred to her that the other banks might simply ignore all the risk controls.’
Tett’s book may not have the intensely dramatic flavour of William Cohan’s book about the Bear Stearns collapse, House of Cards, partly because she eliminates the profanities from the utterances of her interviewees. Nonetheless, it excels in its analysis, explaining how the regulators were foxed by shadow banking.
Concentrating on the story as seen from the J.P. Morgan point of view gives her book its dramatic spine, though she misses a wrinkle or two – for example, what about the impact on the structured-credit world of London-based French business-school graduates with their blind faith in financial engineering?
T he last couple of chapters, from the Northern Rock crisis onwards, are less compelling for the simple reason that we are more familiar with that part of the story. As an academically trained social anthropologist, she identifies the ‘silo’ mentality of bankers as the principal problem. This was particularly true of the arcane world of structured credit with its hankering for mathematical abstraction.
Tett’s policy recommendations for the future may be too vague, but her analysis of what happened is so far without peer.